Valuation Issues with Respect to Preferred Stock
The value of a
preferred stock lacking any common equity kicker, such as convertibility or other special features,
is equal to the present value of its future income
stream discounted at its required yield of rate of return
There are two basic types of equity ownership in a
corporation: common stock and preferred stock. While there is a seemingly
endless amount of information that addresses the valuation of common equity,
guidance on the valuation of preferred equity is less abundant. This article
provides a brief background on the nature of preferred stock, its typical
features, and how these features may impact the value of a particular preferred
The main characteristic of preferred stock is that
the holder is contractually promised to be paid a fixed dividend every period
until its expiration. This dividend is typically required to be paid before any
dividend can be paid to the common stockholders, hence the term “preferred.”
In addition to the stated dividend, preferred stock
can have many other characteristics that distinguish it from the common stock.
For example, preferred stock usually has a preference over common stock in the
event that the corporation liquidates (“liquidation” in the context of preferred
stock refers to the sale of the business or its assets, as well as the
completion of an initial public offering of the company’s common stock).
Preferred stock falls between debt and common stock
in legal priority, privilege, and risk of ownership. While the investor in
preferred stock may be surrendering some of the “upside” potential that common
shareholders have, the preferred stockholder will expect to be protected from
some of the “downside” potential by demanding special characteristics and
The special characteristics of the preferred stock
that are typically encountered are addressed below.
Dividend rate. The most common form
of dividend is one that is fixed at an amount usually stated as a percentage of
the preferred stock’s par value. The value attributable to the stated dividend
rate of the preferred stock depends on the issuing company’s current and
expected ability to pay the stated dividend rate and the current market yields
of preferred stocks with similar dividend payment risk. A somewhat less common
form of dividend is an adjustable-rate dividend, which typically is adjustable
within a stated range and pegged to the general level of interest rates.
Liquidation preference. Another
important characteristic of a preferred stock is its liquidation preference and
the subject company’s ability to pay it in full at liquidation. In almost all
cases, preferred stock carries a contractual right to preference (advantage) in
the distribution of the issuing corporation’s assets upon liquidation. The
preferred stock’s liquidation preference usually is stated as a certain dollar
amount per share. Revenue Ruling 83-120 requires that the issuing corporation’s
ability to pay the full liquidation preference at liquidation be taken into
account in estimating the preferred stock’s fair market value.
Cumulative versus noncumulative
The term cumulative, when applied to preferred stock dividends, means
that if the dividends are not paid for one or more periods, the corporation has
a contractual obligation to make up the lapsed payments before declaring and
paying any dividends on the common stock or on other junior issues. Furthermore,
many cumulative issues also give preferred stockholders voting rights and/or the
right to elect one or more members to the board of directors following the
nonpayment of one or more dividends. Cumulative dividends imply that the risk of
nonpayment of dividends becomes secondary, because the cumulative feature
requires that the shareholder not suffer a loss in income in the long run unless
the company is never able to pay.
In addition, when dividends are cumulative,
liquidation coverage tends to become more important than dividend coverage,
because in the event of liquidation, cumulative dividends in arrears must be
paid in addition to the stated liquidation preference before making any assets
available for distribution to common shareholders.
In general, all other things being equal, the value
of a noncumulative preferred stock would be significantly less than an otherwise
comparable cumulative preferred stock, because dividends not paid on a
noncumulative issue are lost permanently. Revenue Ruling 83-120 also addresses
the cumulative versus noncumulative feature.
Redeemable versus nonredeemable. In
many instances, a preferred stock has a contractual redemption provision. The
type of redemption provision can vary significantly. The most common forms of
redemption provisions are as follow:
The entire issue is redeemable at the option of
the issuing corporation at a specified price (typically par value) over a
designated time period. These types of issues are commonly referred to as
The entire issue is redeemable at the option of
the issuing corporation at a specified price contingent upon a certain
event, such as the death of a major shareholder, a change in ownership
control, or issuance of other securities.
Future redemption by the issuing company is
mandatory and based on a specific redemption schedule. These types of issues
have sinking-fund provisions similar to the vehicle by which bonds are
retired at intervals up to their maturity dates, and are referred to as
sinking fund preferreds.
The impact on value of the redemption privilege
varies depending on the specific redemption provisions. Therefore, it is
extremely important that the analyst be aware of all the contractual
provisions and contingencies of the redemption.
Put options. A common characteristic
of closely held preferred stock is a put option on the preferred shareholder’s
behalf. This option allows the shareholder to require the issuing corporation to
buy back the stock at some fixed price, usually par value. When a preferred
stock can be put back to the company at par value, its value usually is, at a
minimum, its par value, assuming the company has the financial ability to honor
nonvoting rights. In
general, voting rights increase the value of preferred stock. Numerous studies
of publicly traded preferred stocks have been conducted in an attempt to isolate
the reduction in yield (and thus increase in value) investors accord to voting
Participating versus nonparticipating rights.
A participating preferred stock gives the preferred stockholder the right to
share in additional earnings beyond the amount or stated dividend rate described
in the preferred stock contract. On the other hand, a nonparticipating preferred
stockholder can receive dividends only in the amount specified in the contract.
A fully participating preferred stock allows the stockholder to share with the
common stockholder in any earnings disbursements after the common stockholders
have received a certain specified annual payment. The incremental amount to the
preferred shareholders in such a case normally is equal to that paid to the
common stockholders. The value of the participating feature in a preferred stock
is derived from the stockholder’s right to potentially higher dividends and
depends on the likelihood that these potentially higher dividends will in fact
Convertible versus nonconvertible rights.
Convertible preferred stock is similar to a convertible bond in that it is a
combination of a preferred stock issue and an option on a common equity issue.
The conversion feature gives the preferred stock a speculative quality – derived
through future dividend payments – in addition to its investment value as a
fixed-income security. Because of the speculative quality that the equity
conversion feature imparts to the preferred stock, the stock’s value depends not
only on its conversion rights and expected future income stream but on the value
of the common stock as well.
Simply stated, the value of a preferred stock
lacking any common equity kicker, such as convertibility or other special
features, is equal to the present value of its future income stream discounted
at its required yield of rate of return. The higher the risk inherent in the
investment, the higher the required yield.
The difficulties encountered in valuing preferred
stock result primarily from estimating the required yield rate given the stock’s
myriad characteristics. Because of the flexibility in characteristics, the
ability to estimate the value of preferred stock often depends more on the
analyst’s experience and subjective judgment than on observable market evidence.